Is My Fund a Closet Indexer?

Question: I've long held Selected American (SLADX) as a core holding, and I've noticed that its R-squared has been steadily rising and is now over 97. Does that mean the fund is a closet indexer?

Answer: As Esther Pak explored in a series on fund performance statistics this past spring, the "Ratings and Risk" tab for mutual funds is a treasure trove of useful risk/reward statistics for mutual funds. One of these statistics is R-squared, which can be helpful on a couple of fronts.

First, if you're using statistics like alpha and beta to measure a fund's risk/reward profile, R-squared can help you determine how much weight to put on those numbers, as outlined in this article. That's because alpha and beta measure a fund's risk-adjusted return and risk level, respectively, relative to a benchmark. But if a fund has little in common with that benchmark, you'd know not to put much weight on any statistics that are calculated relative to that index.

Take Royce Special Equity (RYSEX), for example. It has a sky-high alpha relative to the S&P 500 Index, meaning its risk/return profile looks much better than the index's. But its R-squared with the index is about 87, indicating that performance has been somewhat correlated with large-cap U.S. stocks, but it hasn't tracked the S&P 500 closely. Morningstar's small-cap core index is a much better benchmark for Royce Special Equity--the two have a correlation of 96--indicating you can safely put more weight on the alpha and beta statistics calculated relative to that benchmark. (Happily for shareholders of the Royce fund, it also looks great relative to the small-cap index index.) 

Eyeballing R-squared can also help you assemble a portfolio of investments that are complementary rather than redundant. For example, let's say you had a broad bond market index fund like Vanguard Total Bond Market Index (VBMFX) as your core bond holding, but you're considering adding a small position in Loomis Sayles Bond (LSBRX) to diversify. Good choice--the fund's R-squared with the Barclays Capital U.S. Aggregate Bond Index is low--under 25 over the past three-, five-, and 10-year periods--meaning that the two funds often perform very differently. The website assetcorrelations.com is also useful if you'd like to get your arms around which asset classes tend to sync up with one another and which do not. (Best asset pair? Large-cap stocks and TIPS or a total bond market index fund. Worst asset pair? Large-cap stocks and mid-cap stocks.)

Finally, you can also use R-squared to gauge if a fund exhibits a performance pattern that's similar to an index. In the case of Selected American, you're correct that the fund's R-squared with the S&P 500 is on the high side and getting higher--it's 94 over the past 10 years and 97 over the past three- and five-year periods. That's a strong indication that on days when the S&P 500 goes up, so does the fund, and the fund also tends to lose on days when the index loses money.

That's useful information, and it also corroborates what we know about the evolution of the fund's strategy. While in the past it was heavily reliant on the financial-services industry--its stake there once consumed more than half the portfolio--its sector positioning is more mainstream these days. Although it still has double the S&P's weight in financials, it has branched out over the past several years, building robust positions in the energy and consumer-defensive sectors.

At the same time, however, it's important to understand what R-squared does not tell you. While it helps you gauge whether two investments have generally moved in the same direction, performance-wise, it doesn't tell you anything about the magnitude of those moves. For example, Rydex 2X S&P 500 , an exchange-traded fund, aims to double the S&P 500's return (or loss) on any given day: On days when the index is up, it strives to gain twice as much; meanwhile, its goal is to be down by twice as much when the index loses. It has a nearly perfect R-squared with the index of almost 100, but investors in the fund have had a very different experience than those in plain-vanilla S&P 500 Index funds. For the year to date, for example, the leveraged ETF has lost about 5% whereas plain index-fund holders have just about broken even.

In a similar vein, Selected American has tended to move in the same general direction as the index, but it has gained more at various points in time (2009) and lost substantially more in others (2008 and the year to date). While the fund has underperformed the index over the past five years, it's a stretch to call it a closet index fund. In fact, its R-squared of 97 is only a touch higher than that of the typical actively managed large-blend fund (94).

Arguably a better measure of whether a fund is an index tracker is a statistic called active share, which Ryan Leggio discussed in this article. In contrast with R-squared, which measures correlation by performance, active share compares holdings of two portfolios to see how much overlap there is (or isn't). Based on that measure, Selected American has a reasonably high active share, meaning that it differs meaningfully from its S&P 500 benchmark in terms of its positions and weightings. (Active share isn't available for every fund on the site, but you can see recent active share statistics for all of our large-cap Analyst Picks here.) That's comfortably above the threshold that active share's creators, K.J. Martijn Cremers and Antti Petajisto, set for closet indexers in their study; they considered funds with active share levels below 60 to be closet indexers.